Cost of Equity Definition
Cost of Equity is a measure used in analysis and valuation which tells you the rate of return required by an investor (including dividends) to incentivize them to take the risk of investing in the company.
If the return offered is too low, then the cost of equity is said to be too high for the investor and they will look elsewhere for returns.
Financial theory suggests that as the risk of investing in a firm increases (decreases), the cost of equity increases (decreases). This follows the logical risk / reward patterns.
For example, assume an investor requires 15% return annually on their investment. The share price of a firm is currently trading at $100 and pays a dividend of $2. The investor requires a total return of $15 per $100 invested, so the share price would have to increase by $13 ($115 - $2 - $100) in order to meet the 15% cost of equity.
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